According to the permanent-income hypothesis, how does your consumption change i
ID: 1108576 • Letter: A
Question
According to the permanent-income hypothesis, how does your consumption change in each of the following scenarios? To keep things simple, suppose the interest rate is 10% and you will live forever. Feel free to give answers that involve approximations.
b) You receive an unexpected promotion today that raises your income permanently by $5,000 per year.
c) To balance its budget, the government levies a onetime tax this year that costs you $10,000.
d) You win a lottery, which pays you a onetime amount of $10 million today.
e) You win a different lottery, which pays you a onetime amount of $10 million, but the payment is made 5 years from now.
Explanation / Answer
According to permanent income hypothesis, the personal consumption does not depend upon the current rise of income or the momentary income, but because of his long term expected income which is impacted by the current scenario. This is against the Keynesian framework of MPC (Marginal Propensity to Consume) that believes that with the rise in income consumption rises. Milton Friedman had given the theory of Permanent Income Hypothesis.
Taking this ito view, answers to the questions may be given as follows.
Answer (a)
Considering the long term expected income, I will compare whether te present 10 % interest shall be sustainable in future. Should I consume or put my earning in saving for assurance of long term income. I would ot like my standard of living to be eroded by wasteful expenditure.
Answer (b)
If I get unexpected promotion and my salary is raised $5000 annually, my standard of living will be upgraded by $5000 per annum. Accordingly my expenditure shall rise in sync with the rise in income. I might think of investing in more productive channel for raising the future standard. Naturally, I might save some amount from the income for the future.
Answer (c)
Just to balance, when the government would impose one time tax of $10000 this year, I would first balance the tax proposal, and thereafter I might raise the personal consumption as I did in question (b)
Answer (d)
Similarly winning a lottery of $10 million will be evaluated on my future expectations. I might think of changing my car and go for limousine. Personal consumption in such case might rise more, but not without considering the future.
Answer (e)
As above it may be answered. I will keep my consumption constant till I get the lottery.
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